chapter: Oligopoly Krugman/Wells Economics 2009 Worth Publishers 1 of 35

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1 chapter: 15 >> Oligopoly Krugman/Wells Economics 2009 Worth Publishers 1 of 35

2 WHAT YOU WILL LEARN IN THIS CHAPTER The meaning of oligopoly, and why it occurs Why oligopolists have an incentive to act in ways that reduce their combined profit, and why they can benefit from collusion How our understanding of oligopoly can be enhanced by using game theory, especially the concept of the prisoners dilemma How repeated interactions among oligopolists can help them achieve tacit collusion How oligopoly works in practice, under the legal constraints of antitrust policy 2 of 35

3 The Prevalence of Oligopoly In addition to perfect competition and monopoly, oligopoly and monopolistic competition are also important types of market structure. They are forms of imperfect competition. Oligopoly is a common market structure. It arises from the same forces that lead to monopoly, except in weaker form. It is an industry with only a small number of producers. A producer in such an industry is known as an oligopolist. When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition. 3 of 35

4 ECONOMICS IN ACTION Is it an oligopoly, or not? To get a better picture of market structure, economists often use a measure called the Herfindahl Hirschman Index, or HHI. The HHI for an industry is the square of each firm s share of market sales summed over the firms in the industry. For example, if an industry contains only 3 firms and their market shares are 60%, 25%, and 15%, then the HHI for the industry is: HHI = = 4,450 4 of 35

5 ECONOMICS IN ACTION Is it an oligopoly, or not? According to Justice Department guidelines, an HHI below 1,000 indicates a strongly competitive market, between 1,000 and 1,800 indicates a somewhat competitive market, and over 1,800 indicates an oligopoly. In an industry with an HHI over 1,000, a merger that results in a significant increase in the HHI will receive special scrutiny and is likely to be disallowed. 5 of 35

6 Some Oligopolistic Industries 6 of 35

7 Understanding Oligopoly Some of the key issues in oligopoly can be understood by looking at the simplest case, a duopoly. An oligopoly consisting of only two firms is a duopoly. Each firm is a duopolist. With only two firms in the industry, each would realize that by producing more it would drive down the market price. So each firm would, like a monopolist, realize that profits would be higher if it limited its production. So how much will the two firms produce? 7 of 35

8 Understanding Oligopoly One possibility is that the two companies will engage in collusion Sellers engage in collusion when they cooperate to raise each others profits. The strongest form of collusion is a cartel, an agreement by several producers to obey output restrictions in order to increase their joint profits. They may also engage in non-cooperative behavior, ignoring the effects of their actions on each others profits. 8 of 35

9 Understanding Oligopoly By acting as if they were a single monopolist, oligopolists can maximize their combined profits. So there is an incentive to form a cartel. However, each firm has an incentive to cheat to produce more than it is supposed to under the cartel agreement. So there are two principal outcomes: successful collusion or behaving non-cooperatively by cheating. When firms ignore the effects of their actions on each others profits, they engage in non cooperative behavior. It is likely to be easier to achieve informal collusion when firms in an industry face capacity constraints. 9 of 35

10 Competing in Prices vs. Competing in Quantities Firms may decide to engage in quantity or price competition: The basic insight of the quantity competition (or the Cournot model) is that when firms are restricted in how much they can produce, it is easier for them to avoid excessive competition and to divvy up the market, thereby pricing above marginal cost and earning profits. It is easier for them to achieve an outcome that looks like collusion without a formal agreement. 10 of 35

11 Competing in Prices vs. Competing in Quantities The logic behind the price competition (or the Bertrand model) is that when firms produce perfect substitutes and have sufficient capacity to satisfy demand when price is equal to marginal cost, then each firm will be compelled to engage in competition by undercutting its rival s price until the price reaches marginal cost that is, perfect competition. 11 of 35

12 GLOBAL COMPARISON Europe Levels the Playing Field for Coke and Pepsi In the United States, Coke and Pepsi have maintained relatively similar market shares: 44% versus 32% in In that same year, thanks to the exclusivity deals that Coke regularly signed with shops, bars, and restaurants across Europe, Coke s market shares in Europe were several times Pepsi s, as you can see in the graph that is, until European regulators finally made their move, also in Not surprisingly, Pepsi applauded the change in European policy toward exclusive dealing. 12 of 35

13 GLOBAL COMPARISON Europe Levels the Playing Field for Coke and Pepsi Coke and Pepsi market shares Coke Pepsi 75% 68% 60% 50 51% 44% 32% 25 5% 6% 5% 0 Belgium France Germany United States 13 of 35

14 ECONOMICS IN ACTION The Great Vitamin Conspiracy In the late 1990s, some of the world s largest drug companies agreed to pay billions of dollars in damages to customers after being convicted of a huge conspiracy to rig the world vitamin market. The conspiracy began in 1989 when the Swiss company Roche and the German company BASF began secret talks about setting prices and dividing up markets for bulk vitamins sold mainly to other companies. How could it have happened? The main answer probably lies in different national traditions about how to treat oligopolists. The United States has a long tradition of taking tough legal action against price-fixing. European governments, however, have historically been much less stringent. 14 of 35

15 The Prisoners Dilemma When the decisions of two or more firms significantly affect each others profits, they are in a situation of interdependence. The study of behavior in situations of interdependence is known as game theory. The reward received by a player in a game, such as the profit earned by an oligopolist, is that player s payoff. A payoff matrix shows how the payoff to each of the participants in a two player game depends on the actions of both. Such a matrix helps us analyze interdependence. 15 of 35

16 ADM A Payoff Matrix Ajinomoto Produce 30 million pounds Ajinomoto makes $180 million profit. Produce 40 million pounds Ajinomoto makes $200 million profit. Produce 30 million pounds ADM makes $180 million profit ADM makes $150 million profit Ajinomoto makes $160 million profit. Ajinomoto makes $150 million profit. Produce 40 million pounds ADM makes $200 million profit ADM makes $160million profit 16 of 35

17 The Prisoners Dilemma Economists use game theory to study firms behavior when there is interdependence between their payoffs. The game can be represented with a payoff matrix. Depending on the payoffs, a player may or may not have a dominant strategy. When each firm has an incentive to cheat, but both are worse off if both cheat, the situation is known as a prisoners dilemma. The game based on two premises: (1) Each player has an incentive to choose an action that benefits itself at the other player s expense. (2) When both players act in this way, both are worse off than if they had acted cooperatively. 17 of 35

18 The Prisoners Dilemma Thelma Louise Don t confess Confess Louise gets 5-year sentence Louise gets 2-year sentence Don t confess Thelma gets 5-year sentence. Thelma gets 20-year sentence. Louise gets 20-year sentence Louise gets 15-year sentence Confess Thelma gets 2-year sentence. Thelma gets 15-year sentence. 18 of 35

19 The Prisoners Dilemma An action is a dominant strategy when it is a player s best action regardless of the action taken by the other player. Depending on the payoffs, a player may or may not have a dominant strategy. A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players. 19 of 35

20 Overcoming the Prisoners Dilemma Repeated Interaction and Tacit Collusion Players who don t take their interdependence into account arrive at a Nash, or non-cooperative, equilibrium. But if a game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior. In repeated prisoners dilemma games, tit for tat is often a good strategy, leading to successful tacit collusion. Tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period. When firms limit production and raise prices in a way that raises each others profits, even though they have not made any formal agreement, they are engaged in tacit collusion. 20 of 35

21 ADM How Repeated Interaction Can Support Collusion Ajinomoto Tit for tat Always cheat Ajinomoto makes $180 million profit each year. Ajinomoto makes $200 million profit 1 st year, $160 profit each later year. Tit for tat ADM makes $180 million profit each year. ADM makes $150 million profit 1 st year, $160 million profit each later year. Always cheat Ajinomoto makes $150 million profit 1 st year, $160 million profit each later year. Ajinomoto makes $160 million profit each year. ADM makes $200 million profit 1 st year, $160 million profit each later year. ADM makes $160 million profit each year. 21 of 35

22 The Kinked Demand Curve An oligopolist who believes she will lose a substantial number of sales if she reduces output and increases her price but will gain only a few additional sales if she increases output and lowers her price, away from the tacit collusion outcome, faces a kinked demand curve- very flat above the kink and very steep below the kink. It illustrates how tacit collusion can make an oligopolist unresponsive to changes in marginal cost within a certain range when those changes are unique to her. 22 of 35

23 The Kinked Demand Curve Price, cost marginal revenue W Tacit collusion outcome P * MC 1 MC 2 X 1. Any marginal cost in this region Y Q * MR Z D Quantity 2. corresponds to this level of output 23 of 35

24 ECONOMICS IN ACTION OPEC, includes 13 national governments (Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya,Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela). In any given year it is in their combined interest to keep output low and prices high. So how successful is the cartel? Well, it s had its ups and downs. OPEC first demonstrated its muscle in 1974: in the aftermath of a war in the Middle East, several OPEC producers limited their output and they liked the results so much that they decided to continue the practice. 24 of 35

25 ECONOMICS IN ACTION By the mid-1980s, however, there was a growing glut of oil on world markets, and cheating by cashshort OPEC members became widespread. The result, in 1985, was that producers who had tried to play by the rules. The cartel began to act effectively again at the end of the 1990s, thanks largely to the efforts of Mexico s oil minister to orchestrate output reductions. The cartel s actions helped raise the price of oil from less than $10 a barrel in 1998 to a range of $20 to $30 a barrel in of 35

26 The Ups and Downs of the Oil Cartel Price of crude oil (per barrel) $ Crude Oil Prices, (in constant 2006 dollars) Iran-Iraq War Iranian Revolution Yom Kippur War Arab Oil Embargo Series of OPEC output OPEC cuts 10% quota increase Gulf War 9/11/01 Rising world demand and Middle East tensions Year 26 of 35

27 Oligopoly in Practice The Legal Framework Oligopolies operate under legal restrictions in the form of antitrust policy. Antitrust policy are efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies. But many succeed in achieving tacit collusion. Tacit collusion is limited by a number of factors including: large numbers of firms complex products and pricing schemes bargaining power of buyers conflicts of interest among firms. 27 of 35

28 Product Differentiation and Price Leadership When collusion breaks down, there is a price war. To limit competition, oligopolists often engage in product differentiation which is an attempt by a firm to convince buyers that its product is different from the products of other firms in the industry. When products are differentiated, it is sometimes possible for an industry to achieve tacit collusion through price leadership. Oligopolists often avoid competing directly on price, engaging in non-price competition through advertising and other means instead. 28 of 35

29 Product Differentiation and Price Leadership In price leadership, one firm sets its price first, and other firms then follow. Firms that have a tacit understanding not to compete on price often engage in intense nonprice competition, using advertising and other means to try to increase their sales. 29 of 35

30 SUMMARY 1. Many industries are oligopolies: there are only a few sellers. In particular, a duopoly has only two sellers. Oligopolies exist for more or less the same reasons that monopolies exist, but in weaker form. They are characterized by imperfect competition: firms compete but possess market power. 30 of 35

31 SUMMARY 2. Predicting the behavior of oligopolists poses something of a puzzle. The firms in an oligopoly could maximize their combined profits by acting as a cartel, setting output levels for each firm as if they were a single monopolist; to the extent that firms manage to do this, they engage in collusion. But each individual firm has an incentive to produce more than it would in such an arrangement to engage in noncooperative behavior. Informal collusion is likely to be easier to achieve in industries in which firms face capacity constraints. 31 of 35

32 SUMMARY 3. The situation of interdependence, in which each firm s profit depends noticeably on what other firms do, is the subject of game theory. In the case of a game with two players, the payoff of each player depends both on its own actions and on the actions of the other; this interdependence can be represented as a payoff matrix. Depending on the structure of payoffs in the payoff matrix, a player may have a dominant strategy an action that is always the best regardless of the other player s actions. 32 of 35

33 SUMMARY 4. Duopolists face a particular type of game known as a prisoners dilemma; if each acts independently in its own interest, the resulting Nash equilibrium or Noncooperative equilibrium will be bad for both. However, firms that expect to play a game repeatedly tend to engage in strategic behavior, trying to influence each other s future actions. A particular strategy that seems to work well in such situations is tit for tat, which often leads to tacit collusion. 5. The kinked demand curve illustrates how an oligopolist that faces unique changes in its marginal cost within a certain range may choose not to adjust its output and price in order to avoid a breakdown in tacit collusion. 33 of 35

34 SUMMARY 6. In order to limit the ability of oligopolists to collude and act like monopolists, most governments pursue an antitrust policy designed to make collusion more difficult. In practice, however, tacit collusion is widespread. 7. A variety of factors make tacit collusion difficult: large numbers of firms, complex products and pricing, differences in interests, and bargaining power of buyers. When tacit collusion breaks down, there is a price war. Oligopolists try to avoid price wars in various ways, such as through product differentiation and through price leadership, in which one firm sets prices for the industry. Another is through nonprice competition, like advertising. 34 of 35

35 The End of Chapter 15 coming attraction Chapter 16: Monopolistic Competition and Product Differentiation 35 of 35